Citi View

Joshua Rosner is Managing Director at independent research consultancy Graham Fisher & Co and advises regulators and institutional investors on housing and mortgage finance issues. Previously he was the Managing Director of financial services research for Medley Global Advisors. In early 2003 Mr. Rosner was among the first analysts to identify operational and accounting problems at the Government Sponsored Enterprises, in the third quarter of 2005 Mr. Rosner identified the peak in the housing market, In October of 2006 Mr. Rosner highlighted the likely contagion from structured securities and credit markets into the real economy.

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Please refer to important disclosures at the end of this report.

Citi View

February 23, 2009
Joshua Rosner
646/652-6207
jrosner -at- graham-fisher.com

Discussions about the stress test continued over the weekend – they were inextricable tied to Citi rumors. We should hear new details this week.

Unfortunately, I expect that the market will find the approaches too complex, to opaque, too reliant on complex instruments and, therefore, too obvious in their attempts to deny the dire reality of the situation – a few large banks won’t be able to survive.

Instead of doing the straightforward thing and getting it behind us, I expect the Administration to continue, a now long tradition, of pushing the problem to another day and thus will allow losses to rise materially even from here. I don’t believe this is done with improper intentions but rather as a result of a lack of personnel with appropriate experience in capital markets and in
resolving bad institutions.

While conversations in Washington and Wall Street are posited as discussions about “the banks”, they continue to ultimately appear to be discussions about Citi. It is true that as Corporate loan losses rise to record levels (I estimate late Q3) and construction loans head that way as well (Q2/Q3), the conversation will be about a few more large institutions. Up to this time, everything we have done seems to have been done with Citi forefront in Treasury’s mind. This only supports the view that our approach should be to get ahead of the curve on the largest and most complex resolutions so we have some experience and so that we have fewer resolutions to juggle 6 months from now.

Unfortunately, all indications are that the government continues to argue that they “can’t dilute the equity holders too much or the companies would never be able to raise capital in the private markets”. Oh, the absurdity… they are toast! They are not going to be able to raise private capital. They need to be cleaned out and resolved. Buyers will always come back to invest in an attractive company with good prospects. Nothing we do, short of resolving and restructuring it, or truly abusing the taxpayer, will ever result in an attractive investment opportunity in a Citi whose prospects are bright.

Then officials say “but if we issue public cease and desist orders to these sick large banks (Citi), as is the regular way to demonstrate a degree of control, it would spook the markets”. Are you kidding, have you looked at where the indices are or where the relevant stocks are trading? The markets are way ahead of policymakers. Only cutting off the head of the beast would calm markets at this point. The faster we demonstrate a willingness to kill the terminally wounded the sooner the viable will begin to trade based on fundamentals and not faulty assumptions.

Addressing Citi is not as complex as people (mostly within the NY Fed and Treasury) argue it is.
Part of the problem is the visceral and gut reaction people have to the word “nationalization”. We must remember that word, like love, means different things to different people. The FDIC ‘nationalizes’ depository institutions every week – they seize them and either do open market sales of the viable
businesses to strategic buyers (sometimes with imputed bridge financing) or they wind down the institution. During this process the law requires a parent holding company to act as a source of strength to its depository.

We could do this with Citi. Yes, it is a larger scale than typical but it is achievable. As a friend said “let the FDIC be the FDIC”. Depending on the capital we need to provide up-front we should expressely wipe out or dilute – on a dollar for dollar basis – the equity, we can then provide 6-9 months of bridge financing which would finance operations while it was being sold off in pieces. We could then begin to auction off business units. As this process unfolds it will become clearer how large the losses will be after considering depositors and secured debt holders. As the process goes on the Company will become smaller and more manageable and investors up the capital structure will have more insight into the value of their preferred or debt investments. Depositors are insured, as are certain debt holders, the government would be wise to say this every time they walk out in public.

There are only a couple of large banks that are likely to find themselves in such a critical condition that they might be handled this way – making the process manageable. If we provided bridge funding to acquirers of some of their units some of those buyers might actually become healthier. Remember, this doesn’t even necessarily mean that the government will replace existing management at this time. Prior to the current, failed, approach to Fannie and Freddie, the managements of those companies rant
them under a very effective consent decree for several years. That is the management template.

I must add that, unlike the usual public process of proposed rulemaking which puts forward and idea and then seeks public comments to be considered and incorporated into the, this Treasury continues in the opaque and secret manner of the last Treasury. They hold secret meetings with select
interested parties, as they are doing today and tomorrow on the modification plan, and thus create an unleveled playing field. More importantly, this approach is precisely the reason that they are not trusted and that the markets are selling off.